Behavioral Finance

“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.”

– Seth Klarman.

When Warren Buffett famously stated that investing was simple but not easy, he meant that the rules we ought to use in order to make good investment decisions are easy to learn but actually adhering to them is difficult. Disregarding rules while investing cannot be attributed to open rebellion but can be ascribed to the basic human survival instincts that have been ingrained in us since time immemorial. Certain traits favored in the process of Natural Selection and helped our ancestors survive in the jungle actually do not help in the market.Read More

It is important to remember that all investments are subject to a certain amount of risk. ‘Risk” can simply be defined as the probability of losing whole or part of the sum invested. This probability must be considered before investing. Various tools may be employed to identify investment-worthy stocks such as fundamental analysis, price-to-earnings ratio, technical and quantitative analysis. Fund managers may combine two or more systems to determine the strength of investment.

By and large, traditional investment strategies are based on a fixed percentage mix of stocks, bonds, and cash for varying risk tolerances. It is often the money manager’s job to select the best investment options based on various theories that can be based on the long-term average performance of investment assets. For example, a moderate risk investor is likely to keep fully invested in 60 percent stock and 40 percent bond allocation without taking into consideration the risk. Institutions and fund managers may follow a relative investment approach, which in our opinion, has fundamental flaws as it focuses on short-term horizons and fails to incorporate emerging trends.

Since June 2015, we have been voicing our concern on market valuations on mid and small cap space. Irrespective of events like Brexit, demonetization or outcome of US elections, market momentum in mid and small cap space has been undeterred.

Since May 2014 with the outcome of Indian elections and NDA government coming in majority, we believe market has rallied on a complete hope based story where the gap between valuations and fundamentals has widened significantly. Focus has shifted from strong conventional businesses to emerging and turnaround stories where we believe the premiums paid are very high.

It is usually in a market like this when behavioural biases overpower an investor’s cognitive decision making ability where greed takes a precedence to rational thinking.

“Ben felt that what I do now makes sense for my situation. It still has its founding in Graham, but it does have more of a qualitative dimension to it because, for one thing, we manage such large sums of money that you can’t go around and find these relatively small value-price discrepancies anymore. Instead, we have to place larger bets, and that involves looking at more criteria, not all of them quantitative. Ben would say that what I do now makes sense, but he would say that it’s much harder for most people to do.” – Warren Buffett 1 responding on apparent divergence from Graham, emphasis ours.

“The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage.” –Charlie Munger

“Not everything that counts can be counted, and not everything that can be counted counts.” – William Bruce Cameron 2

The high profile listing of social media company Twitter in the last quarter of 2013 and the much anticipated Initial Public Offering (IPO) of Chinese e-commerce giant Alibaba Group Holding in the subsequent quarter – are just one of the several signs of a rejuvenating global IPO market.